How Are Negative Correlations Used in Risk Management?

Negative correlation is a statistical measure used to describe the relationship between two variables. When two variables are negatively correlated, one variable decreases as the other increases, and vice versa. Negative correlations between two investments are used in risk management to diversify, or mitigate, the risk associated with a portfolio.

Understanding Negative Correlations

Risk management is a process used in decision-making to identify and analyze the risk associated with an investment. Investors, portfolio managers, and risk managers use this idea to analyze and attempt to quantify the level of potential losses associated with an investment portfolio, and take the appropriate action given the investment objectives and risk tolerance associated with the portfolio.

Key Takeaways

  • Correlations are negative when the prices of the two investments move in different directions.
  • Risk management is the process of evaluating and mitigating the risks of a portfolio.
  • Diversifying the portfolio with non-correlated assets can mitigate volatility and risk.
  • Buying a put option is a tactic used to hedge stocks or portfolios because the put is negatively correlated with the underlying instrument that it is derived from.

Negative correlations of investments are used with portfolio risk management to decide how to allocate assets. Portfolio managers and investors believe that some of the risk associated with the portfolio would be diversified if they can assemble a portfolio of negatively correlated assets. The strategy of assembling negatively correlated assets might be appropriate, for example, if a portfolio manager is forecasting a market crash or in times of high volatility.

A portfolio manager's strategy during times of high volatility is often to manage the risk in his portfolio properly and combine assets to produce a low volatility portfolio. Using negatively correlated investments helps to reduce the overall volatility of the portfolio.

Examples of Using Negative Correlations

A portfolio manager invests in stocks in the oil sector. However, over the past six months, oil stocks have been declining due to oversupply of crude oil, which caused prices to fall by 50%. The manager believes that oil prices will continue to fall and may even crash in the short term but still wants to own the stocks for long-term investing.

Negative correlations of assets can be used to diversify the oil sector portfolio and reduce risk. Some sectors that are negatively correlated with the oil sector are aerospace, airlines, and casino gaming. The portfolio manager may look to sell a portion of his investments in the oil sector and buy stocks that are associated with the negatively correlated sectors.

The portfolio manager can also hedge the portfolio to reduce risk. Hedging reduces the risk associated with an investment or a portfolio by taking positions that will offset losses on the existing holdings in the portfolio. In this sense, negative correlations are used to hedge risk. Instead of diversifying the portfolio, which can use too much buying power, the portfolio manager can use negatively correlated assets to mitigate some of the risk within the oil sector.

For example, buying put options on stocks is a strategy that can be included within the portfolio and will reduce risk. Since put options increase in value as the price of the underlying stock falls, the option strategy is negatively correlated with stocks and buying puts will mitigate risks of the portfolio. There is a tradeoff, however, as the put options cost money to buy and will lose value if the stocks rise in value.

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